Please answer all parts for upvote. a) If the coupon rate of an inflation protec

Question

Please answer all parts for upvote.

a) If the coupon rate of an inflation protection bond (TIPS) is 2.75% and it is sold at par or $1,000.

b) What is the annual real return on this bond for a buy and hold investor. Assume inflation is +2%.

c) If the coupon rate of an inflation protection bond (TIPS) is 2.75% and it is sold at par or $1,000. What is the annual real return on this bond for a buy and hold investor. Assume inflation is -2% (that is, minus 2%).

d) List 3 important features of inflation protection bonds. Explain each feature in 3 lines.

Explanation / Answer

a) Annual Real Return on bond = Nominal Coupon Interest Rate + Inflation Rate

                                          = 2.75% + 2% = 4.75%

If inflation is going to be less than 2% in next years than one would buy the bond and if inflation is going to be more than 2% than investor would like to hold the bond

b) Annual Real Return on bond = Nominal Coupon Interest Rate + Inflation Rate

                                          = 2.75% + (-2%) = 0.75

c) The three important feautures of inflation protection bonds

Protection from inflation Risk - The major risk of fixed income investments is inflation risk that the future interest rates will be less as they would not include in inflation factor and due to which the purchasing power would be less but in these bonds the interest rate received are adjusted as per future inflation which provides better purchasing power benefit.

Coupon Payments: The coupon payments under this bond are paid semi annually adjusted with inflation

Benefit when Inflation rate increases: This bonds will have benefit when inflation rate is higher or at increasing trend, since coupon rates are adjusted for inflation rate which gives real rate of return if inflation rate is decreasing the coupon rate are accordingly reduced and investors would get less interest rates as compared to other fixed-income investments

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